Hedging Our Debts

Weaponizing Inflation and Debt

It’s the 2016 U.S. presidential campaign. The economy never recovered from the housing crash. Both major-party candidates have been generating plans to help the economy, but justifiably cynical voters aren’t buying them.

It’s the 2016 U.S. presidential campaign. The economy never recovered from the housing crash. Both major-party candidates have been generating plans to help the economy, but justifiably cynical voters aren’t buying them.

Then one candidate delivers a bold way to save the federal government trillions of dollars. The scheme strikes most voters as immoral, but in these difficult times economic morality seems to be a luxury, so voters overwhelmingly support the proposal: to repudiate the government’s $22 trillion debt.

Our government borrows money at lower interest rates than anyone else because U.S. Treasury securities are considered the safest investments in the world. But our debt — in 2009 — is $11 trillion and growing rapidly. If the economy doesn’t recover and government spending continues to accelerate, our debt could easily double in seven years. Voters tired of paying high taxes to finance the debt just might welcome a politician who promises to cancel their $22 trillion burden.

China, our biggest creditor, has expressed concern about the security of its U.S. Treasury holdings. Premier Wen Jiabao recently said: “We have loaned a huge amount of money to the United States. Of course we are concerned about the safety of our assets. To be honest, I am a little worried.”

Bill Gross, head of Pimco, the world’s largest bond investment house, has said the United States could eventually lose its top bond rating. Ratings fall only when the risk of default is perceived to have risen. A drop in our bond rating will raise interest rates on our new borrowings, increasing our debt and making it more likely we’ll someday default.

The U.S. government could use rapid but temporary inflation to “softly” repudiate its debt. All our debt is owed in dollars, so inflation lowers the real value of existing debt. The Federal Reserve Board normally tries to prevent inflation, but in the future it might announce that, say, for the next year, monetary policy would double general price levels. This would result in the real value of our debt being halved. Then at year’s end, inflation would be quickly decreased to near zero.

The Chinese are terrified of inflation repudiation. The president of the Federal Reserve Bank of Dallas said he was asked about it during a trip to China “about a hundred times.”

Another scenario for debt repudiation also involves China. If that country were to make a military conquest of Taiwan — which is somewhat likely — it might give the U.S. president an excuse to cancel the debt we owe China, currently $740 billion.

China considers Taiwan a renegade province that it has a right to take by force. The United States, however, considers Taiwan an ally and has sort of pledged to protect it. If China were to invade Taiwan, China’s nuclear weapons might deter us from intervening, so we’d likely impose economic sanctions. The sanction most beneficial to us would be repudiating our debt to China.

Then there’s the presidential campaign scenario. Imagine Barack Obama is re-elected in 2012 and continues to run up a huge debt. A Republican presidential candidate in 2016 might find it politically advantageous to tell voters that future generations shouldn’t have to pay off the “Obama debt.” Voters might agree and support the candidate’s proposal to repudiate all that we owe.

James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Sur­viv­ing and Thriving in a Smarter, Richer and More Dang­erous World (BenBella Books), on sale in October.